The US Federal Reserve today unveiled a radical plan to help provide much-needed funding to the troubled banking sector.

Faced with the ongoing financial crisis, the Fed has decided to try to unblock the credit markets by starting to buy commercial paper — the short-term funding that many companies rely on to underpin their operations.

The London market also took heart from the move, with the FTSE 100 index rallying by 124 points to 4713.4 by mid-afternoon, recovering some of the massive losses of yesterday, its worst day's trading since 1987.

More than 1,000 US companies issue commercial paper, which are effectively IOUs from one firm to another. Commercial paper has become increasingly important in the credit crunch, as long-term funding between banks has almost dried up. Until today the Fed had declined to accept commercial paper, but was forced to act after the market shrunk in recent weeks.

The Fed said in a statement that it was setting up a special purpose vehicle to purchase three-month unsecured and asset-backed commercial paper.

"Difficulties placing commercial paper have made it more difficult for financial intermediaries to play their vital role in meeting the credit needs of businesses and households," said the Fed.

"By eliminating much of the risk that eligible issuers will not be able to repay investors by rolling over their maturing commercial paper operations, this facility should encourage investors to once again engage in term lending in the commercial paper market."

Analysts said it was vital the UK government acts quickly and introduces a coordinated rescue package. This could see up to £50bn injected into the sector in return for the government taking significant stakes in the banks.